I'm back after a couple of weeks in Barcelona teaching a class and a little bit of family time. I hope everyone is having a great summer.
In the last installment, I talked about managing risk in film investments. Today I'd like to look at some of the typical structures that film investments take, putting them in approximate order from least risky to most risky. Of course, the more risk involved, the higher the return that is offered. However, I am not going to get into the specific amounts or nature of returns as the article would simply become too long. If you are interested in more details on any of these deal structures, please feel free to contact me and I'll be happy to discuss.
Many states and countries offer financial incentives to induce producers of film and television to come use their locations, facilities and personnel. This is a means of stimulating economic activity for their region, as well as promoting the area when it is featured in films and TV programs. Some of the most popular incentives are from the states of New Mexico, Louisiana, Georgia and New York, as well as various provinces in Canada. However, there are many other incentives available in the US and around the world.
If a producer wants to use these incentives as a part of the financing for the film, he or she must initially borrow funds from a lender who will then be repaid when the production is complete and the incentive is collected. The good thing for the lender is that the repayment and return on investment is not dependent on how the film does at the box office. The incentive is normally paid even if the film is not ultimately distributed. This means not only is the money repaid sooner (increasing the annualized ROI), but it is very predictable. And if there is a completion bond, then it is even safer because the completion of production is guaranteed.
Foreign Presale Loans.
Quite often, producers will retain the services of a foreign sales agent prior to producing the film. This agent will begin selling the right to distribute the film in various foreign territories. These foreign sale contracts then become collateral for loans which can be used as a part of the production budget for the film.
These senior (first position) loans are again, for the most part, not dependent on the box office performance of the film for repayment. The foreign sale contracts include a payment that will be made upon delivery of the film, and that amount forms the basis for calculating the loan. Therefore, so long as the film is delivered and the foreign distributor honors the contract, the lender is repaid with a profit.
The risk comes when a foreign distributor defaults on the contract, or the film is not completed (although a completion bond is normally a requirement for these types of deals). Also, some of these contracts are conditioned on a domestic (United States) release of the film. So, if the film does not get a domestic distributor or the distributor elects not to release the film in theaters, then some of the foreign contracts might not perform. These are all factors which need to be looked at and managed carefully in making these types of loans.
Foreign "Gap" Loans.
There is often some confusion among producers and some financiers as to what constitutes a "gap" loan. The name seems to indicate that it fills the "gap" in the financing structure. However, a traditional gap loan is a loan that is secured by unsold foreign territories. In other words, the gap lender is entitled to be repaid through the collection of proceeds of sales from territories in which no contract yet exists.
The obvious increased risk here is that there is no guarantee that those sales will occur or what amount will be paid in those territories. While there are some methods for assessing projected sales (primarily based on estimates from a qualified foreign sales agent), the repayment of gap loans can be significantly impacted by the ultimate quality of the film. This makes the investment more dependent on the performance of the filmmakers, and thus riskier than other senior debt.
Unsecured or Mezzanine Debt.
Although less common, some film financing structures include a second level of debt which sits behind the senior lenders in terms of repayment and security (the way a mezzanine floor sits below a main floor in a building). Because these mezzanine lenders are taking a junior position, not only do they typically receive a higher rate of interest, they also receive some portion of the profits from the film in the event it is commercially successful. Therefore, this type of investment is often viewed as a hybrid between debt and equity. In fact, it will sometimes be presented as a senior equity position rather than a junior debt position. However, at the end of the day, it is still occupying the same place in the waterfall when proceeds are distributed.
As with every business investment, the equity holders are the investors taking the biggest risk of the venture losing money, but also receiving the bulk of the rewards if the business is successful. In a film investment, equity participants can make a lot of money if the film is a box office hit. However, they are also at risk of losing most or all of their investment if the film fails to earn back the costs of production and distribution. This might be because of the ultimate quality of the film, a miscalculation in marketing, or simply because audiences decided to see something else instead.
As with any leveraged investment, the amount of debt in front of the equity can have a significant impact on whether the equity investors lose all of their money. However, the payoff for this leverage risk is the increased return on investment in the event a profit is realized, as less money can be invested in order to get the same returns thus increasing the annualized ROI percentage.
This is a very simplified discussion of the various structures typically used in film investing. Each of these deal types has dozens of nuances that can be negotiated and adjusted in order to further manage the risk and potential returns. Again I have to emphasize that investors really need the advice of someone experienced with these types of deals in order to make sure the best possible terms are included. In fact, even those of us with a lot of experience will sometimes get a second opinion from a colleague just to be sure we're seeing things clearly and not missing something that might make a significant difference in the deal.
Of course, if you'd like to discuss any of these deal structures in more detail, or if you have any questions at all about entertainment financing or related topics, please feel free to contact me. Entertainment finance is not merely my profession, but also my passion. I am always eager to discuss new deals or structures, or merely hear about what other people are doing in this space. It's how I stay informed and remain abreast of new developments.
Thanks for following this series.